This Document Contains Chapters 4 to 5 Chapter 4 Equilibrium: How Supply and Demand Determine Prices Learning Objectives After completing this chapter, students should: > be able to find equilibrium price and quantity on a graph and explain the process that generates equilibrium. > understand why equilibrium maximizes gains from trade (measured by the sum of consumer and producer surplus) and why no other price or quantity does. > be able to show with a graph and to explain with words how changes that shift supply and demand will affect equilibrium price and quantity. > understand the difference between a change in demand and a change in quantity demanded and between a change in supply and a change in quantity supplied. > have a fundamentally sound understanding of how using supply and demand analysis can help them explain the world around them. Chapter Outline Equilibrium and the Adjustment Process Who Competes with Whom? A Free Market Maximizes Producer Plus Consumer Surplus (the Gains from Trade) Does the Model Work? Evidence from the Laboratory Shifting Demand and Supply Curves Terminology: Demand Compared with Quantity Demanded and Supply Compared with Quantity Supplied Understanding the Price of Oil Takeaway Chapter Narrative This chapter continues to use the market for oil to teach supply and demand analysis. Hypothetical prices are used to teach the process of achieving equilibrium, the analysis of gains from trade using consumer surplus and producer surplus, and shifts in the supply and demand curves. The chapter concludes with a history of the real-world price of oil and the historical events that have influenced the market. It is easy to tie shifting supply and demand graphs to that narrative to reinforce the real-world relevance of what the students learned in the chapter. Equilibrium and the Adjustment Process It’s time to teach students how to put supply and demand together on the same graph. In the last chapter, we simply assumed a certain price in discussions of supply and demand. Now, students need to learn how price is determined. Start by putting supply and demand together in a diagram like Figure 4.1 in the text. Figure 4.1 Price Is Determined by Supply and Demand The market equilibrium is the point where the two curves intersect. From the equilibrium point, trace down and over to the axes to find the equilibrium quantity and price. At equilibrium, quantity supplied equals quantity demanded and there is no pressure to change either the price or the quantity. There is a state of balance, which is why the word equilibrium is used. If no outside force causes a change in supply or demand, the market is at equilibrium and will remain at this point until circumstances change. Teaching Tip: It may be useful to start with a basic definition of the word equilibrium from a dictionary. Such a definition should describe a state of balance between the different forces in question. It is important to explain that free markets will naturally tend toward equilibrium. And once equilibrium is reached, the market will remain stable until circumstances change. The diagram on the first page of this chapter in the text provides a nice illustration of the equilibrium concept. You might also consider pointing out any student that has a soda or a cup of coffee in class. Ask them what is going to happen to the temperature of their drink as they sit in class. They will likely respond that it will either get warmer or colder until it reaches room temperature. You can then point out that they know exactly what an equilibrium is. Any point on the graph other than the equilibrium is unstable. We can use shortages and surpluses to illustrate how these unstable points converge through the market process to settle at equilibrium. Teaching Tip: You may want to refer to shortages as an excess demand and surplus as an excess supply because students sometimes get the idea of consumer and producer surplus confused with a surplus of goods. Using the phrases excess supply and excess demand prevents this confusion. A surplus occurs when quantity supplied exceeds quantity demanded. Pick any price above equilibrium and trace out the surplus, as illustrated in the left panel of Figure 4.2 in the text. In this situation, the suppliers are offering more goods than buyers are willing to purchase at that price. Figure 4.2 A Surplus Drives Prices Down A Shortage Drives Prices Up Ask the students about a situation that they are familiar with, such as when winter is almost over and stores still have winter coats on the rack. Stores were obviously trying to sell more coats than customers wanted. How do the stores solve their problem? A sale! They have to lower their price to entice more buyers, increasing the quantity demanded. As the market price goes down, manufacturers are less willing to keep producing more coats, and the quantity supplied to the market decreases. In the graph, this is shown by sliding down along the supply and demand curves. This process will continue until the quantity supplied and the quantity demanded are equal. At that point, buyers will demand all of the goods sellers are willing to supply, so there is no further reason to lower prices. A shortage occurs when quantity demanded is greater than quantity supplied. A shortage occurs any time the price is below the equilibrium. Start a new graph. Pick any price below the equilibrium and trace out a shortage, as shown in the right panel of Figure 4.2. In this situation, more buyers want the good than sellers are willing to produce. Students should again have an intuitive feel for what will happen. Ask them about the latest good that was new and extremely popular at Christmas, like the Nintendo Wii was in 2007. There was probably a shortage, and the price started getting bid up. Explain how, as buyers compete to get the good, they have to offer higher and higher prices to get the good instead of (or from) someone else who wants the same good. The higher prices induce suppliers to increase their quantity supplied. Eventually, prices keep getting bid up until an equilibrium is achieved and there is no further pressure to adjust price. In the case of the Wii, retailers didn’t have the authority to charge a higher price, but some buyers who were lucky enough to buy a Wii at its low price turned around and resold them at higher prices on eBay; other people had to wait in long lines to buy a Wii. Explain to students that even when sticker prices do not change, the effective price of the good will rise in response to a shortage. The key to resolving both shortages and surpluses is that competition pushes prices toward the equilibrium in free markets. In fact, another way of thinking about equilibrium is to think of it as the only point where there is no tendency for prices to change. Potential Pitfall: Students often believe that consumers and producers compete against each other. Now is a good time to emphasize that it’s the competition between different sellers who all want to sell their products that induces sellers to reduce their prices when there is a surplus. Similarly, when there is a shortage, it is competition between different consumers all wanting the same scarce good which causes them to try to outbid each other. Sellers compete with sellers, and buyers compete with buyers. The MRU video The Equilibrium Price demonstrates how the equilibrium price is determined in a market, with surpluses driving price down toward the equilibrium price and shortages driving price up toward the equilibrium. Gains from Trade Are Maximized at the Equilibrium Price and Quantity When a market is in equilibrium, all of the gains from trade are maximized for producers and consumers. You can relate this to consumer and producer surplus, which were covered in Chapter 3. Maximizing gains from trade means maximizing producer surplus plus consumer surplus. Start by drawing a simple supply and demand diagram and picking any quantity to the left of equilibrium, as shown in panel A of Figure 4.3 in the text. At a quantity of 24, buyers valued the good at $57, as measured by the height of the demand curve. Sellers were willing to supply the good for a price of only $15, as shown by the height of the supply curve. The net distance between those two points is the total gains from trade, in this case $42. Any price between $57 and $15 would make both the buyer and the seller better off. We can generalize by saying that any time the demand curve is above the supply curve, it signals that buyers value the good more than the sellers and that both parties could be better off if they exchanged the good. Illustrate with a few vertical lines that gains from trade will occur at all quantities until the equilibrium quantity is reached. Next draw a vertical line at a quantity to the right of equilibrium, as shown in panel B of Figure 4.3. Sellers and buyers have no gains from trade here because it costs the sellers more to supply the good than the buyers are willing to pay for it. It is not possible for both parties to benefit from making a trade at quantities to the right of equilibrium. It is important to stress why points to the right of equilibrium result in wasted resources or are “inefficient.” There is still a demand curve, so buyers get some value from the good. But it is inefficient to supply these goods because the resources required to produce the goods, like labor and materials, could be better used to generate more consumer or producer surplus elsewhere in the economy. It is inefficient to produce quantities greater than equilibrium because of the opportunity cost of inputs. Figure 4.3 At the Equilibrium Quantity There Are No Unexploited Gains from Trade or Any Wasteful Trades Teaching Tip: The wasted resources or inefficiency of overproduction is often more difficult for students to understand than the inefficiency of not realizing the gains from trade. A couple of examples of how the opportunity cost of the resources could have produced more value elsewhere can help them understand. Maximizing gains from trade requires taking advantage of all potential gains from trade. That is, the entire area of consumer surplus and producer surplus must be realized. This can occur only at the equilibrium quantity. Any quantity less than the equilibrium quantity will leave some potential gains from trade unexploited. Maximizing gains from trade also requires that no trades occur for which the costs of production exceed consumers’ willingness to pay, since such trades would reduce consumer and producer surplus. It is useful to think of these wasteful trades as subtracting from consumer and producer surplus. This is the case for any trades that exceed the equilibrium quantity. The result is that any quantity below or above the equilibrium quantity will provide less than the maximum amount of consumer surplus plus producer surplus. This is shown graphically in Figure 4.4 in the text. To summarize, it takes three conditions to maximize gains from trade (as measured by consumer plus producer surplus): The supply of goods is bought by the buyers with the highest willingness to pay. The supply of goods is sold by the sellers with the lowest costs of production. There are neither unexploited gains from trade nor any wasteful trades. The MRU video Exploring Equilibrium reviews the market equilibrium and price adjustment process along with an illustration of how gains from trade are maximized at the equilibrium. Does the Model Work? Evidence from the Laboratory This section of the chapter introduces students to Vernon Smith’s work, which pioneered experimental economics. Smith won the 2002 Nobel Prize for his work in experimental economics. It explains how he designed a simple classroom experiment to allow students to perform as either buyers or sellers and bid against each other. Smith knew the supply and demand schedules, but the students knew only their own buyer value or seller cost. To Smith’s surprise, prices and quantities quickly converged to equilibrium values. You can lecture on this part of the chapter to your students, but it would be far more effective to illustrate it by actually conducting an in-class experiment yourself and letting your students determine the efficiency of the market. A simple experimental design is suggested at the end of this chapter. The first half of the MRU video Does the Equilibrium Model Work provides a nice illustration of Vernon Smith’s path-breaking experiment, which showed that equilibrium indeed prevails in markets. Shifting Demand and Supply Curves Tying together what the students learned in the last chapter about shifts in demand and supply with what they have just learned about market equilibrium will help them understand how changes in prices and quantities occur in the real world. Start with an example of the effect of a decrease in sellers’ costs. From an initial supply and demand diagram in equilibrium, shift the supply curve out and to the right. Explain that the market was in equilibrium, but now the decreased cost has made sellers more willing to supply the good at any price than they were before. Trace across from the old equilibrium price to illustrate the surplus after the supply curve shifts. Then explain how a surplus will lower prices and thus increase the quantity demanded and decrease the quantity supplied until the new equilibrium point is reached. The text does not illustrate the impact of a decrease in supply, so this might be a good time to see how well the students are able to figure it out on their own. Ask students to draw a supply and demand graph. Then ask them to shift the supply curve and find the new equilibrium price and quantity if all workers required higher wages. Give them a few minutes to work it out for themselves so they will know if they are having a hard time understanding. Then explain that this change in wages would increase sellers’ costs, so they would require higher prices to provide any given quantity, and so the supply curve would shift in and to the left. Then draw a line from the old equilibrium to illustrate the shortage that would occur at the old price and how prices would be bid up, thus decreasing the quantity demanded until the new equilibrium is reached. Teaching Tip: You might consider breaking this down into specific steps and presenting it as a check list for students to use whenever a market is “shocked” (it even has the acronym I DEAR). Step 1: Identify the Shock: Take the shock (such as technological advance or increase in popularity of an item) and link it to one of the shift factors discussed in Chapter 3. Step 2: Draw the Shock: Move whichever curve is impacted by the identified shift factor. Step 3: Excess Quantity Supplied or Excess Quantity Demanded: Look at the new quantity demanded and quantity supplied at the original price. Which way does this move prices? Step 4: Adjust price: Move the price until you reach the point where quantity supplied equals quantity demanded again. Step 5: Report the Results: Report the new equilibrium price and quantity and discuss how each of them changed as a result of the shock. The text illustrates what happens with an increase in demand but does not illustrate a decrease in demand. It might again be useful first to explain the process of adjustment for an increase in demand and then give the students an example of decreased demand with a few minutes to figure it out for themselves. Teaching Tip: This might be a good time to give a number of examples for students to work out on their own. Students are often tempted to memorize what the picture looks like when an increase or decrease in demand or supply occurs. The key for their future success is to develop a real understanding of the model so they can reason out what will happen. This is best accomplished by giving them a few problems to work out where you don’t tell them which curve to move. Here are some examples to try that are not in the text: > Consider the market for oranges. Graph the appropriate shift and identify the new equilibrium price and quantity if: a severe hurricane hits Florida. doctors discover more beneficial health effects of vitamin C (found in oranges). many immigrants move into Florida, lowering agricultural labor costs. the price of apple juice falls. > Consider the market for new cars. Graph the appropriate shift and identify the new equilibrium price and quantity if: the price of gasoline rises significantly. the price of steel falls significantly. the U.S. government spends large sums to develop a better commuter rail system. the United States enters a major war and has a large demand for tanks and other military vehicles. The last half of the MRU video Does the Equilibrium Model Work provides several examples of how shifting curves in the supply and demand framework is a powerful tool for helping us understand everyday events. Terminology: Demand Compared to Quantity Demanded and Supply Compared to Quantity Supplied The importance of understanding the difference between “changes in demand or supply” and “changes in quantity demanded or quantity supplied” was introduced in the previous chapter. It is crucial to emphasize the difference in terminology in the examples. > A change in demand or supply is a shift of the entire curve. This occurs when anything other than price changes. > A change in quantity demanded or quantity supplied is a movement along a given curve. This is caused by a change in price. A change in supply is always accompanied by a change in quantity demanded, because at the old equilibrium price a shortage or surplus will cause a movement along a given demand curve as price adjusts to the new equilibrium. A change in demand is also accompanied by a change in quantity supplied, because a shortage or surplus will cause a movement along a given supply curve as price adjusts to the new equilibrium. This is worth pointing out graphically, as shown in Figure 4.8 in the text, so students understand the difference. Teaching Tip: When working out examples in class, get students used to the difference in terminology by explicitly writing out in words what has happened in each graph—whether a change in demand or supply has occurred and the corresponding change in quantity supplied or quantity demanded. The MRU video Supply and Demand Terminology illustrates the difference between changes in demand/supply and changes in quantity demanded/supplied. Understanding the Price of Oil The price of oil has varied significantly over the past 50 years, as shown in Figure 4.9 in the text. This provides an excellent tool to illustrate the impact of supply and demand shifts in a real-world market that is familiar to most students. It may be useful to show the figure in class or roughly sketch it on the board. Then point to specific years, mention a real-world event, and ask them to draw a supply and demand diagram that illustrates that event. Connect what their diagrams predict to what actually happened to world prices. Here is a list of events: > In the early 1970s, many OPEC countries nationalize oil, and the Yom Kippur War makes OPEC desire to punish Western countries that support Israel. > The Iranian Revolution ends the monarchy in 1979. > Iran and Iraq go to war in 1980. > New oil production from non-OPEC countries begins coming online and expanding from the 1970s through the 1980s. By 1982, non-OPEC oil production exceeds OPEC oil production for the first time. Iranian oil production also begins to recover. > The Persian Gulf War is fought in 1991. > In 1997, an East Asian financial crisis slows the growth of many countries in East Asia. > In the early twenty-first century, China and India grow dramatically, raising the income of billions of people. > In 2008, a global financial crisis slows worldwide growth. > In 2014, new drilling technologies increase U.S. oil production to record levels. Figure 4.9 The Price of Oil, 1960–Present Takeaway The importance of this chapter cannot be overemphasized. Students will be well prepared if they can: > explain how competition eliminates surpluses and shortages to move markets to equilibrium. > explain why the gains from trade as measured by consumer surplus plus producer surplus are maximized only at the equilibrium price and quantity. >demonstrate how supply and demand shifts change equilibrium prices and quantities, given a variety of problems that do not explicitly tell them which curve to shift. > recognize the difference between a change in demand or supply and a change in quantity demanded or quantity supplied. In- and Out-of-Class Activities Market Equilibrium Experiment Conducting an experiment to illustrate market equilibrium can serve as a powerful teaching tool. Many software packages can link students at computer terminals, match buyers and sellers, and automatically calculate how efficient the market was. If you don’t have access to such programs or a computer lab, a simple experiment can be done manually in a traditional classroom. Be sure to stress to students that their goal (just as in real life) is to maximize their own surplus. Thus, buyers should buy at the lowest price they can, and sellers should sell at the highest price they can. Offering extra-credit points based on surplus generated might be a good way to encourage them, but beware that this will require additional record keeping on your part. You will need to do the following: Make a set of cards with buyer values and seller costs on them. Each card will represent one spot on the demand or supply curve. If you have between 20 and 30 students in your class, you should make enough cards so that each student has one. In larger classes, you should have some students pair up and work as a team with a single card. Otherwise, the process takes longer and is harder to control. Set the equilibrium to be generated by your supply and demand schedules. The equilibrium should be set so more than half, perhaps even three-quarters, of your students have an opportunity to reap gains from exchange. Assigning too many cards to the right of the equilibrium value will leave too many students standing around without being able to find a partner. You must assign some students values to the right of equilibrium, though; otherwise there is limited potential for the market to be inefficient. Have the buyers and sellers stand facing each other and allow them to call out offers. You should stand at the blackboard. When two parties agree to a trade, they should come to you together to record their trade on the blackboard, and then they should remain away from the rest of the group. Once no other people remaining are able to agree (or a suitable amount of time has passed), reassemble the entire group and allow trading to begin again, starting completely from scratch. You may want to scramble the cards so that students don’t just fall into the same trades from the first round, which will be the easiest thing for them to do. Repeat this process for three to six rounds. By then they should have converged to equilibrium values. Collect the buyer values and seller costs from the students (or, if you did not scramble the cards, have them show you their card one at a time so each student can see who was where on the curves). Use these to plot the supply and demand curve on the blackboard point by point. Show where equilibrium price and quantity should occur. Then compare this with the prices that were traded at each round and the number of trades made. At first you should find some market inefficiency and varying prices. However, by round 3 or 4, most trades should be near equilibrium prices and the correct quantity should be exchanged. Here is a sample buyer value and seller cost schedule for a 20-person experiment. The equilibrium price would be 10, with a quantity of six units traded (or five units if the equilibrium price emerges and the two traders with costs or values of 10 choose not to trade). Buyer Value Seller Cost 20 1 18 3 15 5 14 7 12 8 10 10 8 12 6 14 4 16 2 18 20 1 18 3 15 5 14 7 For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU video: Equilibrium and the Adjustment Process The Equilibrium Price Gains from Trade Are Maximized at the Equilibrium Price and Quantity Exploring Equilibrium Does the Model Work? Evidence from the Laboratory Does the Equilibrium Model Work (first half of video) Shifting Supply and Demand Curves Does the Equilibrium Model Work (last half of video) Terminology: Demand Compared to Quantity Demanded and Supply Compared to Quantity Supplied Supply and Demand Terminology Chapter 5 Elasticity and Its Applications Learning Objectives After completing this chapter, students should: > be able to calculate elasticities of demand and supply using data on prices and quantities. > understand the relationship between total revenue and elasticity. > be able to use elasticities of demand and supply and price change formulas to make quick quantitative predictions about the effects of shifts in demand and supply. > appreciate the relevance of elasticity for understanding a variety of real-world social problems and potential solutions to those problems. Chapter Outline The Elasticity of Demand Determinants of the Elasticity of Demand Calculating the Elasticity of Demand Using the Midpoint Method to Calculate the Elasticity of Demand Total Revenues and the Elasticity of Demand Applications of Demand Elasticity How American Farmers Have Worked Themselves Out of a Job Why the War on Drugs Is Hard to Win The Elasticity of Supply Determinants of the Elasticity of Supply Calculating the Elasticity of Supply Using the Midpoint Method to Calculate the Elasticity of Supply Applications of Supply Elasticity Gun Buyback Programs The Economics of Slave Redemption Using Elasticities for Quick Predictions How Much Would the Price of Oil Fall if the Arctic National Wildlife Refuge Were Opened Up for Drilling? Takeaway Appendix 1: Other Types of Elasticities The Cross-Price Elasticity of Demand The Income Elasticity of Demand Chapter Narrative This chapter develops the students’ understanding of elasticity of supply and demand and illustrates how the concepts can be used to address some important social questions. The chapter begins by telling how, in the fall of 2000, a Harvard sophomore flew to the Sudan to pay for the release of 4,000 slaves. Although students will likely begin with the impression that this was an unambiguously good act, the book questions whether the act of purchasing slaves might have encouraged more slave taking and promises that elasticity will help students figure it out. Other questions explored in this chapter include why the war on drugs can generate more violence, why gun buyback programs are unlikely to work, and how much increased drilling in the Arctic National Wildlife Refuge is likely to affect oil prices. Teaching Tip: Elasticity is traditionally one of the most boring and difficult topics for principles students. The text strives to teach the intuitive aspects of elasticity and to apply elasticity to questions students will find interesting. The more emphasis you can provide for interesting examples rather than focusing on mundane calculations, the more interest and intuition you are likely to get from students. Some of the more traditional (and from a student’s perspective, boring) material is covered in the chapter’s appendices. The chapter itself covers elasticity of demand and supply and uses the simple percentage change formula and the midpoint formula. Appendix 1 covers cross-price elasticities and income elasticity. The material in the appendices can easily be left out of your lectures and exams, can be covered after the main text, or can be integrated into the other material in your lectures. Suggestions for integrating the material are given later in this chapter. The Elasticity of Demand The elasticity of demand measures the sensitivity of the quantity demanded to a change in price. Roughly speaking, when an increase in price greatly reduces the quantity demanded, we say that demand is elastic. When the same increase in price only slightly decreases the quantity demanded, we say that it is inelastic. You can draw two demand curves such as those in Figure 5.1 in the text to illustrate the difference, but be sure to point out that although the slope of the demand curve is related to elasticity, the two are not the same. Figure 5.1 The More Responsive Quantity Demanded Is to a Change in Price, the More Elastic Is the Demand Curve Determinants of the Elasticity of Demand The textbook returns to its prior discussion of oil and asks whether the demand for oil is elastic or inelastic. In the short run, the demand tends to be inelastic because there are few substitutes for oil in its main use, transportation. Demand for oil (and most goods) tends to be more elastic over longer periods because people have more time to invent or invest in substitutes for oil such as better batteries or alternative fuels. Try asking students how many of them drove to class today or how many drive home frequently. Then ask them how their behavior would change if gasoline increased by $0.25 per gallon, and most will say that change will not change their behavior. Keep asking this question but increase in rise in gasoline per gallon price, and you will find a point where most students will say they would have walked to class or would travel home less frequently. Then try asking if any of them might let gas prices affect what they choose for their next car purchase. Then you can point out that all of these things are substitutes, but some take longer than others to implement, and that is why demand tends to be more elastic over time. It’s important to emphasize that what counts as a substitute depends on both the objective properties of the good and the buyer’s preferences. Try asking your students if Coke and Pepsi are substitutes. Most will likely say they are, but you can probably find a few avid adherents of one over the other who wouldn’t switch between products even if there were substantial price differences. For these people, demand is less elastic. Starbucks and Dunkin’ Donuts, McDonald’s and Burger King, Coors Light and Bud Light, and Ford and GM are other examples that would likely get you similar responses. The allocation of income to a good also influences its elasticity. The smaller the portion of a person’s budget that goes to a good, the less elastic the demand is likely to be. A very small portion of most students’ budgets goes to buy pencils. You can ask them if their consumption of pencils would change much if the price rose by 50%. Then try asking them whether a 50% increase in the price of textbooks or dorm rooms would change their consumption. Both of these consume a larger portion of students’ budgets. The difference isn’t explained by the availability of substitutes alone, because in most cases substitutes for pencils are more readily available than substitutes for dorm rooms or books. Table 5.1 in the text summarizes factors that determine the elasticity of demand. It may be worthwhile to refer students to this information. Table 5.1 Some Factors Determining the Elasticity of Demand Less Elastic More Elastic Fewer substitutes More substitutes Short run (less time) Long run (more time) Categories of product Specific brands Necessities Luxuries Small part of budget Large part of budget The MRU video Elasticity of Demand introduces elasticity of demand and provides a detailed discussion of the determinants of elasticity of demand. Calculating the Elasticity of Demand To calculate the elasticity of demand, divide the percent change in quantity demanded by the percent change in price. ■("Elasticity of Demand =" @"E" _"d" " =" "Percentage Change in Quantity Demanded" /"Percentage Change in Price" = (%∆Q_Demanded)/(%∆Price)) Elasticity of demand is always negative, so we often just quote the absolute value. > If elasticity is greater than 1, meaning that the percent change in quantity demanded is bigger than the percent change in price, we say the demand for the good is elastic. > If elasticity is less than 1, meaning that the percent change in quantity demanded is smaller than the percent change in price, we say the demand for the good is inelastic. > If elasticity is exactly equal to 1, meaning that the quantity demanded and the price change by the same proportion, we refer to the demand as unit elastic. If a price increase reduces quantity demanded from 100 to 90, the percent change in quantity demanded depends on what is used as a denominator. If we divide by 100, it’s 10%, but if we divide by 90, it’s 11.1%. To avoid this problem, we use the midpoint quantity and midpoint price when calculating elasticities from price and quantity data. The Midpoint Formula ■("Elasticity of Demand" =@E_d=(%∆Q_"demanded" )/(%∆"Price" )=((Change in Quantity Demanded)/(Average Quantity))/("Change in Price" /"Average Price" )= ((Q_After-Q_Before)/((Q_After+Q_Before)/2))/((P_After-P_Before)/((P_After+P_Before)/2))) Elasticity and Total Revenues A firm’s revenues (R) are equal to price per unit (P) times quantity sold (Q): R=P×Q Because elasticity measures how much Q goes down when P goes up, there is a relationship between elasticity and revenue: > If demand is inelastic, revenue goes up when price rises (or price and revenue move in the same direction). > If demand is elastic, revenue goes down when price rises (or price and revenue move in opposite directions). The textbook illustrates the relationship neatly in Figure 5.3. Figure 5.3 Elasticity and Revenues Try drawing a similar graph on the board for your students. Draw one graph with a steep (relatively inelastic) demand and another with a flatter (relatively elastic) demand. Shade in the total revenue at an initial price and calculate the area of the box (P × Q). Then raise the price in the first graph, shade in the new revenue box, and calculate its area. It’s useful to describe this to students as you draw the changes on the graph, pointing out the revenue lost after the price rises (the fewer units sold multiplied by the old price) and pointing out the size of the revenue gained (the more you make per unit sold). Students tend to be able to follow this comparison of boxes well, understanding what is gained and what is lost. Then ask them to do the same exercise for the flatter, more elastic curve with the same price increase. Encourage students to draw steep and flat demand curves and the boxes of gained and lost revenue to help them think about the relationship between elasticity and revenue. If they can do this, they won’t have to memorize the relationships summarized in Table 5.2. The MRU video Calculating the Elasticity of Demand discusses the mathematics of elasticity of demand, including several worked examples. The last half of the video discusses the relationship between elasticity and total revenue. Applications of Demand Elasticity How American Farmers Have Worked Themselves Out of a Job In 1936, the average grain production per acre in the United States was about 36 bushels, but in 2015 the average was more than 160 bushels per acre. This increase in productivity reduced the cost per acre, causing the supply to increase due to a decrease in the cost of production. This lowered prices for agricultural goods. Elasticity determines how these lower prices affected revenue. Demand tends to be inelastic for many agricultural products. How much milk can you really drink? Even if prices drop dramatically, you are unlikely to consume significantly more. Because the demand is inelastic, total revenue to the farmers decreases, encouraging many to leave their farms for more lucrative jobs in cities. The increase in agricultural productivity has led to fewer farmers. Increased productivity doesn’t always reduce total revenue. As productivity increased in the production of computer chips and prices fell, total revenue soared because the demand for computer chips is elastic. After all, as the price of chips has fallen, we have seen a marked increase in the number of things with computer chips. Why the War on Drugs Is Hard to Win The U.S. government spends more than $40 billion a year arresting over 1.5 million people in an attempt to deter the supply of drugs. These efforts are aimed at decreasing the supply for drugs by increasing the costs of smuggling and dealing. Ask the students if they think the demand for illegal drugs is inelastic or elastic. Follow up with why (few substitutes due to addictive quality) to highlight the determinants of elasticity. The demand for illegal drugs tends to be inelastic. The textbook suggests an estimate of 0.5. So how does the war on drugs affect revenue? Figure 5.5 in the text illustrates. When a demand curve is inelastic and the price rises, sellers’ revenues increase. So the more smuggling costs are increased and supply is reduced, the more revenue goes to the remaining drug dealers, giving them more money with which to bribe officials and buy weapons. The more effective the drug war, the more the drug dealers gain power, making it very hard ever to win the war. Nobel Prize winner Gary Becker has suggested legalizing and taxing drugs to raise their price to the same level as the current prohibition accomplishes. Remind students that a tax shifts the supply curve directly up because taxes also increase the cost of production. The same quantity of drugs would be bought as under prohibition, but now the government, rather than the drug dealers, would gain the increased revenue. Such a policy shift would reduce the gang violence associated with the drug trade and would also be likely to decrease many of the other negative aspects of current drug consumption. Figure 5.5 The Drug War Is Hard to Win Because Seller Revenues Increase with Greater Enforcement Note to Instructor: In Appendix 1, cross-price elasticity of demand and income elasticity of demand are both calculated. If you would like to incorporate this material into your lecture before moving on to elasticity of supply, you might find it fits well here. See the discussion of other elasticity measures later in this chapter of the instructor’s manual. Elasticity of Supply The elasticity of supply measures the sensitivity of the quantity supplied, or by how much quantity supplied will change when there is a change in price. > When a small price increase causes a large increase in the quantity supplied, we say that supply is elastic. > When a large price increase produces only a small increase in quantity supplied, we say that supply is inelastic. You can illustrate the difference by drawing a graph like Figure 5.6 in the text. Figure 5.6 The More Responsive Quantity Supplied Is to a Change in Price, the More Elastic the Supply Curve Determinants of the Elasticity of Supply The main determinant of the elasticity of supply is how quickly per-unit costs increase with an increase in production. In general, an increase in production of raw materials, such as oil, coal, and gold, causes significant increases in costs, so their supply is relatively inelastic. You might remind students what they learned from Chapter 3: The deeper you drill, the higher the cost. Manufactured goods tend to be more elastic because often production can be expanded at the same (or even lower) cost per unit by building more factories. The text uses toothpicks and Picasso paintings to illustrate the polar cases of perfectly elastic and perfectly inelastic supply (see Figure 5.7). You might want to draw each type of curve on the board to discuss them with your students. Figure 5.7 The Elasticity of Supply of Toothpicks and Picasso Paintings Toothpick manufacturers can greatly increase the supply of toothpicks without a significant increase in their costs, just by cutting down a few more trees and running them through their mill. So a small increase in price will generate a large increase in quantity supplied, approximating a horizontal supply curve. Picasso paintings, on the other hand, are very inelastic. No matter how high the cost of Picasso paintings goes, he won’t be painting any more of them. (He is dead, after all.) This will make the supply curve nearly vertical, or almost perfectly inelastic. The curve is not perfectly inelastic: Though Picasso can’t make any new paintings, the existing ones come on the market from time to time. Like demand curves, supply curves tend to be more elastic in the long run than in the short run. If market prices remain high, firms will build new factories or discover new oil fields or invest in new means of production (such as hydraulic fracturing) so that quantity supplied can increase more rapidly and at a lower marginal cost, leading to a more elastic supply curve. Supply is also more elastic when the quantity supplied can be expanded without causing a large increase in the demand for the industry’s inputs. Since toothpicks consume such a small quantity of the total wood produced, doubling toothpick supply isn’t likely to have much of an impact on the price of wood. However, doubling the quantity supplied of housing would have much more of an impact on the price of wood, giving housing a less elastic supply curve. Local supply is usually much more elastic than global supply. If the local price of a good rises, sellers are quickly willing to shift production from lower-priced markets to higher-priced ones, whereas if the global price rises, there is no other place from which to shift supply. Table 5.3 in the text summarizes factors that determine the elasticity of supply. It may be useful to refer your students to this table. Table 5.3 Primary Factors Determining the Elasticity of Supply Less Elastic More Elastic Difficult to increase production at constant unit cost (e.g., some raw materials) Easy to increase production at constant unit cost (e.g., some manufactured goods) Large share of market for inputs Small share of market for inputs Global supply Local supply Short run Long run Calculating the Elasticity of Supply The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in price. E_S=(%∆Q_"supplied" )/(%∆"Price" ) In-Class Exercise: You might try giving students a few quick examples so they are comfortable calculating elasticity of supply. The text uses a 10% rise in the price of cocoa with a 3% rise in quantity supplied, for an elasticity of supply of 0.3. It also uses an increase in the price of coffee by 10% and an increase in the quantity supplied of 1.5%, for an elasticity of supply of 0.15%. Like the elasticity of demand, elasticity of supply can be computed from price and quantity data using the midpoint formula: ■("Elasticity of Supply" =@E_S=(%∆Q_"Supplied" )/(%∆"Price" )=((Change in Quantity Supplied)/(Average Quantity))/("Change in Price" /"Average Price" )=((Q_After-Q_Before)/((Q_"After" +Q_"Before" )/2))/((P_"After" -P_"Before" )/(〖(P〗_"After" +P_"Before" )/2))) The MRU video Elasticity of Supply introduces elasticity of supply and provides a detailed discussion of the determinants of elasticity of supply. The last part of the video discusses the mathematics of elasticity of supply along with several worked examples. Applications of Supply Elasticity Gun Buyback Programs The Los Angeles Police Department offered $100 gift cards for handguns and $200 gift cards for assault weapons, no questions asked, in its “guns for groceries” buyback program. Millions of dollars have been spent in similar programs in many cities. Are the gun buyback programs a good policy? The theory of gun buybacks is that: A) buybacks reduce guns in circulation. B) fewer guns in circulation reduces crime. It’s not clear whether B is true because guns are used in self-defense as well as to commit crimes, but the text does not debate this question. Instead the text uses elasticity of supply to illustrate that A is false. It asks what type of gun is likely to be sold in buybacks and what is the elasticity of supply for guns in a city like Los Angeles. The best guns to sell at a buyback are guns one can’t sell anywhere else or whose price is below that being offered in the buyback. So buybacks tend to attract low-quality guns. In one Seattle buyback 17% of the guns bought weren’t even functional. Local supply also tends to be more elastic than national or global supply. In general, each gun bought in Los Angeles’s buyback program is quickly replaced by another gun. Additionally, gun owners in nearby areas will “shift supply” of low-quality guns from their own home area to the area of the buyback. The book highlights this very fact with a buyback in Oakland, California, which attracted gun owners from Reno, Nevada, 213 miles away. If the supply is sufficiently elastic, the price for low-quality guns will not increase, so the same number will be held as prior to the buyback. Figure 5.8 in the text illustrates with a perfectly elastic supply curve. Figure 5.8 Elasticity and Gun Buybacks It’s even possible that gun buyback programs increase the number of guns in circulation. If a buyback program is permanent, then the program essentially becomes a free insurance policy for gun owners. When your gun breaks or gets old, you are guaranteed you can resell it to the government. Such an insurance policy would increase the demand for new guns. If your students doubt this, you can ask them whether they would be more likely to buy new textbooks if they had a guarantee they could sell them back at the end of the course. The Economics of Slave Redemption Harvard sophomore Jay Williams, working with Christian Solidarity International, was able to buy and free 4,000 slaves from Sudan for an average price of $33 per slave. At first glance students will be tempted to think that this was an unambiguously good deed. However, whether Williams’s actions were beneficial depends critically on the elasticity of the supply of slaves. If the supply curve for slaves is perfectly inelastic, each slave bought is one less slave held in captivity. If, however, the supply curve for slaves is perfectly elastic, then each slave bought and freed is just one more person enslaved for a little while; the total number permanently held in bondage would remain the same. Figure 5.9 in the text illustrates the best case for Williams, a perfectly inelastic supply curve. When demand from slave redeemers augments the demand from traditional slave owners, it has a large impact on price and crowds out much of the demand from those who wish to hold slaves in bondage. Figure 5.9 Slave Redemption Works Best When the Supply Curve for Slaves Is Perfectly Inelastic The textbook does not graph what would happen with a perfectly elastic supply curve for slaves. Here, the same increase in demand has no effect on price. As a result, more total people are enslaved, at least temporarily, and the prior demanders for slaves continue to buy and hold the same number of people in permanent bondage. You might want to draw this graph for students or ask them to draw it for you. When the supply curve is perfectly inelastic, every slave bought by the redeemers is one fewer slave held in captivity, but when the supply curve is perfectly elastic, every slave bought by the redeemers is one additional enslaved person. Figure 5.10 in the text presents an intermediate case. Here, with a standard upward-sloping supply curve, slave redeemers cause both a positive and negative impact on total enslavement. When they increase market demand, the price is pushed up, which crowds out some of the traditional slave owners from the market, though not all of them. Fewer people are held in long-term captivity. Because the price increased, however, the quantity supplied increases, leading to more people in total being enslaved for a little while before being bought and freed. The net number of slaves freed is greater than zero but fewer than the total number purchased by the redeemers. Figure 5.10 Slave Redemption When the Supply Curve Is Not Perfectly Inelastic In this intermediate case, positive economic analysis can’t tell you whether slave redemption is good or bad. All it tells you is that redemption will produce a trade-off. More people will be enslaved for at least a little while, but fewer slaves will be held in long-term bondage. Economics points out this dilemma but does not offer a solution. In Williams’s case, the trade-off doesn’t look very good. One key to obtaining a net decrease in slavery is for the market price to rise when the redeemers enter the market. From what evidence is available from Sudan, it appears that price did rise initially but then soon began to fall. This is some evidence that the market for slaves in Sudan is more elastic over time. The MRU video Applications Using Elasticity illustrates the application of supply elasticity to the slave redemption program (first half of video) and gun buyback programs (last half of video) discussed in this section of the text. The MRU video Elasticity and Slave Redemption illustrates the application of supply elasticity to the slave redemption program discussed in this section of the text. Using Elasticities for Quick Predictions (Optional) Economists constantly shift supply and demand curves to predict what is going to happen. Shifting the curves gives us qualitative predictions about what will happen to price and quantity. Now that students have learned about elasticity, they can use it to make quantitative predictions about price. > Percent Change in Price from a Shift in Demand="Percent Change in Demand" /(E_d+E_s ) >Percent Change in Price from a Shift in Supply ="Percent Change in Supply" /(E_d+E_s ) Make sure to highlight for the students that the values for Ed in these formulas should be entered as absolute values (that is, ignoring the negative sign on the elasticity of demand). How Much Would the Price of Oil Fall if the Arctic National Wildlife Refuge Were Opened Up for Drilling? The Arctic National Wildlife Refuge (ANWR) is believed to hold large quantities of petroleum, and it is often debated whether the refuge should be opened up for drilling. Using elasticities, we can estimate what impact it would have on oil prices if ANWR were drilled. The Department of Energy estimates that production from ANWR could average 800,000 barrels per day, approximately 1% of world oil production. The elasticity of demand for oil is about 0.5, and the elasticity of supply is approximately 0.3. Plugging these into our formula above, we get −1%/(0.5 + 0.3) = −1.25%. Takeaway Hopefully, the nonconventional applications of elasticity have sparked students’ interest in this topic. They should now be able to calculate elasticities of demand and supply and use elasticities to make quantitative predictions about the effects of demand and supply shifts. Appendix 1: Other Types of Elasticities Elasticities can be calculated whenever there is a relationship between two variables. Cross-price elasticity of demand and income elasticity of demand are common examples. The Cross-Price Elasticity of Demand Recall from Chapter 3 that a change in the price of a substitute or compliment will impact the demand for a good. The cross-price elasticity of demand tells us whether and how closely goods are complements and substitutes. The formula for cross-price elasticity of demand is: ■("Cross-Price Elasticity of Demand" =@"Percentage Change in Quantity Demanded of Good A" /"Percentage Change in Price of Good B" =(%∆Q_"Demand,A" )/〖%∆"Price" 〗_B ) If we have data on the quantity demanded of good A for two different prices of good B, then we can calculate cross-price elasticity by: ((Change in Quantity Demanded A)/(Average Quantity A))/("Change in Price B" /"Average Price B" )=((Q_"After,A" -Q_"Before,A" )/((Q_"After,A" 〖+Q〗_"Before,A" )/2))/((P_"After,B" -P_"Before,B" )/((P_"After,B" +P_"Before,B" )/2)) When the cross-price elasticity is greater than zero, the goods are substitutes. When it is less than zero, they are complements. This sometimes is not obvious to students. They mistakenly think that a positive number should be associated with goods that “go together,” or are complements. But in fact, complements have negative cross-price elasticities for the same reason that the price elasticity of demand is negative. Encourage students to be very careful with this and always to think through a hypothetical example (Pepsi and Coke, for example) if they need to answer exam questions about this topic. The Income Elasticity of Demand Recall from Chapter 3 that a change in income will change the demand for a good, but how the demand changes depends on whether the good is a normal or inferior good. The income elasticity of demand measures whether a good is a normal or inferior good and the sensitivity of quantity demanded to changes in buyers’ incomes. The formula is ■("Income Elasticity of Demand" =@"Percentage Change in Quantity Demanded" /"Percentage Change in Income" =(%∆Q_"Demanded" )/(%∆"Income" )) Again with data on quantity, we can calculate the income elasticity of demand as ((Change in Quantity Demanded)/(Average Quantity))/("Change in Income" /"Average Income" )=((Q_After-Q_Before)/((〖Q_After+Q〗_Before )/2))/((I_After-I_Before)/((I_After+I_Before )/2)) We use income elasticity to determine whether goods are normal, inferior, or luxury goods. Luxury goods are a type of normal good. > If income elasticity of demand is greater than zero, it is a normal good. > If income elasticity of demand is less than zero, it is an inferior good. > If income elasticity of demand is greater than 1, it is a luxury good. In- and Out-of-Class Activities This list provides different types of elasticity estimates for various goods. Provide these elasticity estimates to students in class or as a homework assignment for discussion about what a given elasticity indicates about the nature of the product in question. Price elasticity of demand: > Fresh tomatoes: −4.6 > Beefsteak: −1.8 > Packaged coffee: −0.25 > Restaurant meals: −2.3 > Beer: −0.7 Income elasticity of demand: > Packaged coffee: −0.4 > Apples: 0.1 > Beer: −0.5 > Ground beef: 0.7 > Beefsteak: 1.4 Cross-price elasticity of demand: > Beer with wine: 0.8 > Beef with poultry: 0.4 > Beef with fish: −1.0 > Apples with strawberries: −1.0 > Fuel-efficient cars with gasoline: 0.2 For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU Video: The Elasticity of Demand Elasticity of Demand The Elasticity of Demand Calculating the Elasticity of Demand The Elasticity of Supply Elasticity of Supply Applications of Supply Elasticity Elasticity and Slave Redemption Applications of Supply Elasticity Applications Using Elasticity Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766
Download
Close
Close
